Tuesday, May 26, 2009

I have argued for a long time that the credit default swap counterparty risk held by banks is the primary reason that they stopped lending to each other, you know, the so-calloed "credit crisis" or "liquidity crisis", which is reflected in the interbank lending rates (Libor) shooting through the roof.

Massive positions are just starting to be unwound in the credit default swaps market as tens of billions of dollars worth of these contracts are now getting settled in the aftermath of several high-profile flops.

Banks are hoarding cash in expectation of expected payouts on anywhere from $200bn to $1 tn–no one knows the amount, adding to volatility–for defaulted credit derivatives linked to the collapse of Lehman Brothers, the government’s seizure of mortgage giants Fannie Mae and Freddie Mac, the government’s rescue of American International Group, and the failure of Washington Mutual.

This has just been verified yet again, this time by the chief economist at a large Japanese bank:

“It’s premature to judge that the credit meltdown is fully over,” said Kazuto Uchida, chief economist in Tokyo at Bank of Tokyo Mitsubishi UFJ Ltd., a unit of Japan’s largest bank. “Banks remain wary of extending credit to each other due to strenuous concerns about counterparty risk.”....

("Counterparty risk" is, of course, the term for the risk from credit default swaps.)

Once again, from the top . . . the economy cannot even start to fundamentally improve until the trillions of dollars of over-the-counter CDS already out there are either torn up or marked down to a very small nominal amount (say $1 each).

And before you say that is not politically feasible, please read this.

3 comments:

Well, CDS are not the problem...they are a _symptom_ of the problem. The real problem as I see it has basically two parts: 1. fractional reserver lending and 2. the political establishment has essentially merged with the banking system. These two factors combined prevent banks from booking losses (many of them should in fact be out of business). In other words, its the fact the contracts can't be torn up (as they should), not the contracts themselves that are the problem.

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